First, it's time to stop worrying about short-term rates. Those will continue to be manipulated down for the benefit of Uncle Sam, maybe forever.
You should also stop focusing on what Bernanke is saying. His timetable ends in January, and we don't yet know the name or sentiments of his successor.
No matter who is the next chairman, you can be sure that long-term rates are going to rise over the next two years and that the change will be accompanied with significant volatility.
For individuals this is a scary prospect. The natural reaction is to go to cash and ride it out, but the downside is not earning any income on your capital for the next two years.
I say embrace the new financial reality. There is a glut of capital in the world, and economic growth is slow. That means too much money is chasing too few good investment options. Hence, anything that is safe doesn't even pay you the rate of inflation. Witness the negative 0.75% rate on TIPS earlier this year. In this environment, volatility is a plus because it creates investment opportunities.
As an alternative to cash, I would suggest investing in preferred stocks, which are callable anytime. This will provide significant short-term income and very limited volatility. What I call "cushion preferreds" are normally something investors avoid because they can be called in at any time. But it's exactly this feature that now makes them highly attractive given that short-term yields are being manipulated by the Fed.
Many cushion preferreds can be bought today at their call price plus accreted dividends. So you have no risk of loss–even if they're called the next day you are accruing income at their coupon rate during the 30-day notification period. This strategy works for callable bonds, too, but they're not exchange traded and are harder to buy at the right price.
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Here are the ground rules for buying cushion preferreds. First, I recommend a website called Quantumonline.com, which has a trove of data on preferred stocks, or my own website, Incomesecurities.com, which also lists candidates.
Seek out investment-grade issues to minimize credit risk and coupon rates over 6%. Calculate the accreted amount of the next dividend payment and add this to the call price. This sum should be your bid price.
Set a limit order, and be careful not to chase the price. In fact, I find it best to bid on multiple preferreds to increase the chances of getting enough viable investments. It's also important to watch for the ex-dividend date and then adjust your buy price down to the call price. Note your broker's bidding system will generally do this for you automatically. Be cautious of issues selling substantially below their accreted value, as there may be some overriding credit problem.
Here's an example: Barclays Barclays has a 7.75% preferred (BCSpC) that traded at 25.45 just before an Aug. 28 48-cent ex-dividend date. It's callable at $25. On the 28th the price dropped to 25.10. Since it won't be called sooner than Nov. 28, the price will rise to accrue the dividend and, even if called, will yield 6.1% for the three-month holding period. If it's not called for another year, that yield goes to 7.3%.
Yes, interest rates are going up. But my guess is that 6% to 7% for investment-grade preferreds will again become the norm, and these cushion preferreds will find a permanent place in your long-term portfolio.
Richard Lehmann is editor of the Forbes/Lehmann Income Securities Investor and Forbes/ISA Closed End Fund & ETF Report newsletters. He is also the author of Income Investing Today (John Wiley & Sonss, 2007). For more follow him at forbes.com/lehmann.
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